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Oil: pump or store?

Oil: pump or store?
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First Published: Tue, Mar 15 2011. 09 31 PM IST
Updated: Tue, Mar 15 2011. 09 31 PM IST
This column offers three mind games on natural resource strategy.
The first mind game: the wave of democratic aspirations sweeping across the Arab world could change the nature of regimes controlling a large part of global oil supplies. What are the implications?
Nations endowed with immense natural riches tend to be authoritarian. The elites running these countries have no reason to nurture either a robust civil society or a market economy with domestic entrepreneurs and a professional middle class. The state and the men who control it get ample money from selling natural resources to the world, so they have little need for taxes on incomes and profits from the rest of the economy or for a social contract with ordinary citizens. In times of trouble, opposition can be either stamped out or bought over.
Now many of the oil exporters could be moving towards democracy. University of Chicago economist and Nobel laureate Gary Becker wrote in a recent blog post that the effect of democracy on oil production is unclear. Two issues are critical. One, will the new democracies invite efficient global oil companies to produce and refine oil or will they reserve this important sector for government-run oil companies as democratic Mexico and Brazil have done? Two, will the new regimes have a longer horizon than the dictators they replace, who feared they would be overthrown and hence had an incentive to pump oil as fast as possible?
Becker proposed that “regimes that become much more democratic as a result of the current unrest would tend to produce less oil than the autocratic regimes they replaced if they use government-run oil companies, and have a long horizon”. On the other hand, oil production could rise if the new regimes used international oil companies and have a shorter horizon because they need revenues. “I lean toward expecting reductions in oil production from the MENA (Middle East and North Africa) region, and higher world oil prices,” wrote Becker.
The second mind game: the decision of what to do with oil reserves is a complicated one. The basic choice is between pumping out oil right now for cash and leaving it in the ground for future revenue generation: sell or hold? Economist and statistician Harold Hotelling wrote in a celebrated 1931 paper that rational owners of natural resources will decide on this matter after calculating whether the return on money received from pumping oil today is higher or lower than the increase in the value of oil left in the ground. In other words, would you prefer to hold your wealth in the bank or in the ground?
By that measure, it would make far more sense for oil exporting nations to cut back on oil production right now. The value of oil in the ground seems likely to go up in the coming years on strong demand from emerging economies such as India and China. Meanwhile, the financial returns on oil revenues today are minimal thanks to low interest rates in the developed financial markets.
The Interfluidity blog offers two caveats: “The pump-or-store decision should be based on the relative private values of oil and financial investment. If the princes think that, after a revolution, their financial wealth would be frozen by fair-weather patrons in the West, that would tilt things in the opposite direction. The princes might believe that defending their claim to oil in the ground is a better bet than relying upon recently less than reliable Swiss bankers to protect the interests of unpopular clients.”
And: “… the princes would have to be mindful of potential backwards causality from pumping decisions to revolution. If it looks like the rulers are ramping production in a panic, that might signal fear and undermine the government’s legitimacy, aiding the revolutionaries’ cause. However, the current price spike and concerns of oil consumers would provide cover. There are lots of reasons besides fear of regime change why the Saudi government might choose to increase production now, if they can.”
The blog concludes that a strategy of keeping oil in the ground seems “less of a safe bet” than it would have been a few years ago.
The third and final mind game: a strategy titled towards keeping oil in the ground runs the risk of creating incentives for investment in new forms of energy by other economies. Oil exporters have gradually learnt to keep global oil prices in a range. Allow them to go too low and revenues will suffer. Allow them to go too high and the global economy tips over into a recession, hurting oil demand and revenues. But the real long-term worry for oil exporters is that if they decide to keep oil in the ground for too long, rather than monetize it, the value of these reserves could drop in case cheap new forms of energy get developed in the coming years.
Niranjan Rajadhyaksha is managing editor of Mint. Your comments are we- lcome at cafeeconomics@livemint.com
To read Niranjan Rajadhyaksha’s previous columns, go towww.livemint.com/cafeeconomics
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First Published: Tue, Mar 15 2011. 09 31 PM IST